Appeal of Loan Classification (First Quarter 2020)
A national bank supervised by the Office of the Comptroller of the Currency (OCC) filed a second-tier appeal to the OCC's Ombudsman of the decision rendered by the District Deputy Comptroller during a formal appeal. The bank appealed the loss rating assigned to a credit relationship that includes a series of loan participations purchased for the purpose of land acquisition and development. The primary source of repayment was receipt of tax credits, tax increment financing funds, land sales, and take-out loans for the development of projects. The secondary source of repayment was the collateral consisting of all the membership interests in a limited liability company and first deed of trust on various real estate properties.
The appeal argued that the OCC incorrectly applied the "Rating Credit Risk" booklet of the Comptroller's Handbook and the Bank Accounting Advisory Series when rating the credit relationship, and the appeal asserted that a substandard/nonaccrual rating was more appropriate. The appeal contended that the past-due status is a well-defined weakness that could jeopardize the liquidation of the debt, and the appraised value of the collateral, less costs to sell, is sufficient to cover the loan balance. The appeal asserted that the bank's review of the appraisal determined that it met the minimum appraisal standards and included reasonable assumptions and conclusions for the type and character of the collateral. The appeal contended that the supervisory office accepted the appraisal during the prior examination and relied on its value when classifying the loan, thereby implicitly concluding that the appraisal assumptions were reasonable.
The appeal argued that the supervisory office could not conclude that the collection period is unknown since it did not assess the bank's proposed repayment and reduction plan. The appeal disputed the supervisory office's statement that existing litigation and potential lengthy collection efforts supported the loss classification. The appeal disagreed that the project is speculative and contended that the recent paydowns, status of the collateral, and payments expected from anticipated development do not support the determination that the loan is uncollectible. The appeal also disputed the supervisory office's statement that collection is out of the bank's control and argued that the bank has taken steps to assert its control and has rights over the collateral, despite the bank's decision not to foreclose.
The appeal asserted that the loss classification causes a conflict with the treatment prescribed under generally accepted accounting principles (GAAP) and tax accounting.
The Ombudsman conducted a comprehensive review of the information submitted by the bank and relied on the following supervisory standards:
- 12 CFR 30, appendix A, "Interagency Guidelines Establishing Standards for Safety and Soundness"
- 12 CFR 34, subpart C, "Appraisals"
- ASC 310, "Receivables"
- Call Report Instructions
- Comptroller's Handbook, "Rating Credit Risk" (April 2001)
- Comptroller's Handbook, "Commercial Real Estate Lending" (January 2017)
- OCC Bulletin 2009-32, "Commercial Real Estate (CRE) Loans: Guidance on Prudent CRE Loan Workouts"
- OCC Bulletin 2010-42, "Interagency Appraisal and Evaluation Guidelines"
The Ombudsman concurred with the supervisory office's assigned rating of loss due to the uncollectible nature of the debt and the long-term litigation or other lengthy recovery efforts necessary to collect either its principal or interest. Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets are not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. Once an asset is classified as loss, there is little prospect of collecting either its principal or interest. Banks should not maintain an asset on the balance sheet if realizing its value would require long-term litigation or other lengthy recovery efforts. Losses are to be recorded in the period an obligation becomes uncollectible. Refer to the "Rating Credit Risk" booklet of the Comptroller's Handbook.
The Ombudsman determined that the credit relationship is uncollectible and no longer a bankable asset due to the matured status of the loan, lengthy nonperforming status without a viable restructure or repayment plan, protracted and lengthy litigation precluding timely collection, lack of borrower's capacity to repay or guarantor support, uncertain collateral protection, and the bank's unwillingness to enforce required payments or foreclose to collect principal or interest. The primary sources of repayment either are no longer available or have not come to fruition. The tax credits that the borrower relied upon expired several years ago, and efforts to reinstate the program have been unsuccessful. Sales activity and completed projects for the development area have been slow and insufficient in comparison to the size of the project. Discussions of potential developments within the project are positive, but these projects had not received the necessary approvals or secured financing at the time of the supervisory office's loss determination.
The Ombudsman noted that since purchasing the participations more than a decade ago, the bank has received only 20 percent of its total exposure on a highly speculative project that has been matured for over half that period. The Ombudsman noted that 75 percent of the payments received were from the sale of several parcels of land for one of the projects within the redevelopment site. The bank has not enforced the requirement to pay down the loan upon the sale of lots or parcels, and instead allowed the borrower to use proceeds to pay expenses related to the transaction. The bank has not entered into a forbearance agreement or established a formal restructure plan with the borrower despite the relationship's matured status. Instead, the bank advanced additional funds to preserve collateral, further increasing its exposure to this speculative problem credit. The Ombudsman noted that this is an unsafe and unsound practice. The bank had immediately charged off the loans, and the supervisory office directed the bank to charge off additional loans to a related entity. By charging off the notes, bank management recognized the borrower and guarantor's inability to service the debt and the uncollectible nature of the loans.
The Ombudsman concurred with the Deputy Comptroller's conclusion that the project is a stalled redevelopment that is reliant on speculative development of future projects for repayment and an unknown collection period. The Ombudsman noted that the bank has no viable workout strategy, and repayment is reliant on the borrower's ability to stimulate interest in the redevelopment project. The bank's loan action plan states that repayment is reliant on the sale of collateral and does not include plans to foreclose on the collateral and liquidate the property. The bank's collateral valuation places zero value on the membership interests in the limited liability company and the guarantor and has not evaluated the potential for monetizing the pledged partnership interest. The bank's repayment and reduction plan verbally proposed to the supervisory office during the examination is not a viable restructure or repayment plan and lacks the key elements of a prudent workout plan. The Ombudsman noted that legal challenges have plagued the project since inception and the current pending lawsuit continues to prolong the timeline for redevelopment and the eventual collection and recovery efforts.
The Ombudsman determined that collateral protection for the relationship is uncertain. The bank has not completed a new title or lien search for the collateral, consistently applied proceeds from lot sales to reduce principal, or managed control of the matured notes through reservation of rights letters or forbearance agreements. These issues create the potential for legal and credit risks on the collateral. The bank's decision to not foreclose and liquidate the property along with the lack of actions to protect the bank's interests lessen the relevance of the collateral as loss protection for the outstanding loans.
The Ombudsman concluded that the appraisal is not valid and is in violation of 12 CFR 34.44(a) and (e), "Minimum Appraisal Standards." The appraisal did not report the "as is" market value and was based on a hypothetical condition that the subject property was one contiguous, vacant development-ready tract. The subject property was not contiguous, and some lots were improved. In addition, the appraisal report does not conform to the Uniform Standards of Professional Appraisal Practice. The appraisal incorrectly labeled the report as a "Summary Appraisal Report," but also stated that the use of the report was "restricted to the intended user." In addition, the violation cannot be cured given that the bank's exposure to the credit relationship was rated a loss.
The Ombudsman also determined that the bank incorrectly concluded in its appraisal review that the appraisal met minimum appraisal standards for the subject property. The Ombudsman noted that the depth of an institution's appraisal review should be sufficient to ensure that the methods, assumptions, data sources, and conclusions are reasonable, well-supported, and appropriate for the transaction, property, and market. Transactions involving complex properties or high-risk commercial loans should be reviewed more comprehensively to assess the technical quality of the appraiser's analysis. Refer to OCC Bulletin 2010-42. The depth of the bank's appraisal review was limited to a summary of assumptions and comparable sales. Given the complexity and high-risk nature of the project, it would have been prudent for the bank to utilize an independent third-party appraiser with qualifications commensurate with the complexity of the project.
The Ombudsman concluded that the classification of loss does not conflict with the treatment prescribed under GAAP and tax accounting. The risk rating determination is a separate and distinct decision from determining regulatory accounting or financial reporting matters such as nonaccrual status or charge-off. The "Rating Credit Risk" booklet provides guidance on evaluating credit risk and regulatory definitions for loan ratings. Neither GAAP nor regulatory accounting and financial reporting guidance (i.e., call report instructions) defines when or how a loan should be risk rated. As such, neither GAAP nor call report instructions are considered when considering a loan's risk rating classification. ASC Topic 310 provides authoritative guidance on when a loan receivable should be charged off. Per ASC 310-10-35-41, a loan "shall be charged off in the period in which the loans or trade receivables are deemed uncollectible." The Ombudsman noted that the GAAP threshold for charge-off recognition is based on when the loan is deemed uncollectible, which is the same threshold for the regulatory definition of loss; all loans classified as loss are deemed to be uncollectible.